Sector investing is viable, but timing trades offers risks

Andrew LeckeyThe Associated Press

Heard about the average investors who put every cent they had into sector funds for years, brilliantly switching from technology to telecommunications to gold to utilities, amassing a fortune along the way?

No? Well, that's because they don't exist.

The truth is, putting everything into individual market sectors and trying to time them accurately is dangerous even for the savviest pros.

Because of the risks in concentrating too much money in one area, sector investing should, at best, represent only a portion of an individual's portfolio. Investors also must make sure they are not duplicating too many holdings they have in broader-based funds.

Keeping those caveats in mind, however, there is nothing inherently sinister about sector investing so long as you don't get too fancy about it. It is simply putting money into a specific industry area that shows promise, in the same way that an investor selects an individual stock.

"Utilities, materials, telecom and energy have been the strongest sectors thus far in 2007, while financials have not done well due to the subprime lending issues," said David Reilly, director of portfolio strategies for Rydex Investments in Rockville, Md. "Sector investing is worthwhile because, even when major market averages are going sideways or down, there are always some sectors doing better than the market."

Three basic ways to make a sector selection are to choose a sector that looks cheap, is due for an improved business cycle or has price momentum, Reilly said.

"Sector investing makes sense when you want higher returns than with diversified mutual funds but don't want the risk exposure or research burden of picking individual stocks," said Jack Bowers, editor of Fidelity Monitor, a Rocklin, Calif.-based independent newsletter for Fidelity investors. "I like to buy out-of-favor sectors and hold them for a long time."

His patient strategy removes the major criticism leveled at sector investors: They are overly twitchy and switch sectors too often, following rather than leading into trends. Past returns of sector funds point out that the leadership changes regularly.

Looking at the five-year annualized total returns of the 41 Fidelity Select sector funds by category through the first quarter of this year, natural gas led with 22.36 percent, followed by natural resources at 21.86 percent; energy, 21.55 percent; gold, 19.38 percent; and materials, 18.95 percent.

"You can decide what you want your overall equity exposure to be, then take money away from a few of your existing investments and put it into a sector fund," said Andrew Clark, head of research for Lipper Inc. in Denver. "You definitely don't want to just go out and buy what seems hot, since you'd increase your equity exposure that way."

Each sector has different characteristics, risks and rewards, which means there is both conservative and aggressive sector investing. Consider how different sectors will move and interact with each other.

"If you want to invest in sectors, keep a long-term perspective and diversify into different sectors," said Peng Chen, president and chief investment officer for Ibbotson Associates in Chicago. "If someone wants to invest in just one sector and understands the risks involved, then it is OK, although still not what we think an investor should do."

Unlike the typical one-industry sector fund, the $310 million Rydex Sector Rotation Fund H does the switching among sectors for the investor by tracking sector price momentum. It has a three-year annualized return of nearly 18 percent and is up 9 percent this year.

Increasingly popular exchange-traded funds offer opportunities to invest in sectors. An ETF, which consists of a basket of securities designed to track an index such as one for a specific sector, trades like a stock on an exchange.

"A lot of sectors are less correlated to the overall market than many other investments, including foreign markets that tend to be highly correlated to the Standard & Poor's 500," said Michael Krause, president of ETF Research Center in New York. "You could almost look at sectors as their very own asset class, and you can definitely use them to do better than the S&P 500."

-- Energy SPDR, which provides an opportunity for long-term investors regardless of near-term oil price fluctuations because it trades at the lowest price-earnings ratio of sector SPDRs.

-- Financials SPDR, which should see merger and acquisition activity outweigh subprime lending problems, making current earnings estimates overly conservative, he said. It too is priced at a discount.

On the other hand, he sees limited upside potential for the Health Care SPDR and Technology SPDR. While the fundamentals remain strong for the Utilities SPDR, he has some concern over whether the sector's dramatic price gains can continue.